Many managers of investment portfolios employ a set of custom factors in their investment decision-making process. These managers want to know how their decisions impact the risk/return characteristics of the portfolio.
A common practice in today's asset management industry is to use one model for attributing portfolio returns, and to use an entirely different model for attributing risk. For instance, the active return of a portfolio is often decomposed into allocation and selection effect using the sector-based Brinson model. See Brinson, G., and N. Fachler, 1985. “Measuring Non-U.S. Equity Portfolio Performance.” Journal of Portfolio Management, vol. 11, no. 3, (Spring): 73-76. The active risk of that very portfolio, however, is typically attributed to a set of factors within a fundamental factor model. This basic inconsistency obscures the intimate link between the sources of risk and return.
A better approach is to align both the return attribution and risk attribution models to the same underlying investment process. If, for instance, the manager follows a sector-based investment process, then the risk should also be attributed to the allocation and selection decision variables. How to attribute both ex ante and ex post tracking error to the allocation and selection decisions of the portfolio manager has been shown in a prior paper by Menchero and Hu. See Menchero, J., and J. Hu, 2006. “Portfolio Risk Attribution.” Journal of Performance Measurement, vol. 10, no. 3, (Spring): 22-33. Using a consistent framework for attributing both return and risk may provide greater insight into the essential character of the portfolio.
A natural extension of this analysis is to combine return and risk attribution to explain sources of risk-adjusted performance. This results in an attribution of the information ratio reflecting the decision variables of the investment process. Menchero carried out such an analysis for the case of a sector-based investment scheme in another earlier paper. See Menchero, J., 2006/2007. “Risk-adjusted Performance Attribution.” Journal of Performance Measurement, vol. 11, no. 2, (Winter): 22-28. Menchero showed that the portfolio information ratio was the weighted average of the component information ratios for each investment decision. The relevant weights, however, are not the investment weights, but rather the risk weights.
A major outstanding question is how to extend this unified attribution framework for a factor-based investment process, when return, risk, and risk-adjusted performance are attributed to set of custom factors.